My not-so-profound thoughts about valuation, corporate finance and the news of the day!

Tuesday, February 1, 2011

The Shift to Buybacks: Implications for investors

A couple of posts ago, I noted the shift from dividends to stock buybacks at US corporations, a shift that is already starting to have ripple effects in other markets. In 2010, about 60% of the cash returned by S&P 500 companies came from stock buybacks, whereas only 40% took the form of dividends. Since so much of investment lore is built around dividends, there are consequences for investors of all types:

a. The dividend player: In the earliest days of equity markets, the advice given to investors was simple. Find a stock that pays a "big" dividend, and growth then is pure icing on the cake; the dividends will generate cash income while you hold the stock and the growth will provide for price appreciation. Over the decades, there are many investment strategies that have built around this premise, from the "Dow Dogs" (investing in the stocks with the highest dividend yields on the Dow 30) to more sophisticated variants. The academic research has been supportive, as I noted in an earlier post, with high dividend yield stocks generating excess returns, after adjusting for risk.

At first sight, the shift to buybacks may seem like bad news for investors focused on dividends, but I think it actually strengthens their hand. It is true that there are fewer "big" dividend payers than there used to be, but if you buy into the earnings stability argument (that the reason for the shift to buybacks is because companies feel less secure about future earnings), those big dividend payers who remain must feel even more confident about their future earnings potential than the dividend payers of the past. Put in more abstract terms, if increasing dividends was a positive signal in the past (when it was the only option for returning cash), it should be even more so now (when it would be far easier to just buy back stock).

So, what are the caveats? First, the universe of stocks that you can invest in going to be smaller and there may be entire sectors (technology, for instance), where you will find few or no stocks to invest in. Second, watch out for the impostors. These are the companies with unstable earnings that have no business paying large dividends but do so because they want to take advantage of a large and loyal investor base that likes dividends. Bottom line: Focus on stocks that pay large dividends and treat buybacks as noise that you either weight very little or not at all in your investment decision. Screen for stocks that have the earnings to sustain dividends and offer some growth potential, and eliminate companies that have unsustainable dividends (they pay dividends with borrowed money or by selling assets).

b. The "cash" player: There are many investors who want near term cash flows from their investments, but are not particularly attached to dividends. These investors should consider stock buybacks as cash payback, when assessing stocks, since they can always tender a portion of their shares in each buyback. These investors should be adjusting measures like dividend yield and dividend payout, commonly used by "dividend' based investors, to include stock buybacks. In fact, all of these measures can be computed with what I call augmented dividends = dividends + stock buybacks:
Augmented Dividends = Dividends + Stock Buybacks
Augmented Dividend yield = Augmented Dividends/ Market Capitalization
Augmented Dividend payout = Augmented Dividends/ Earnings
Since buybacks are volatile, you should use a normalized or average buyback per year, in computing the augmented dividend.

While this strategy does widen the universe of stocks that you can invest in, it is also more risky than a pure dividend strategy. You cannot count on buybacks; in 2009, for instance, the dividends paid by US companies dropped by 10% in the aggregate but stock buybacks dropped by almost 80%. As I noted in an earlier post, there is a significant sub-section of companies that make themselves less valuable and perhaps even put themselves at risk of distress by buying back stock.Bottom line: Focus on companies that buy back stock for the right reasons - because they are under levered and have few investment opportunities. Stay away from over levered companies that buy back stock with even more borrowed money.

c. The growth player: There are investors who have little interest or need for near term cash but are much more focused on long term growth and price appreciation. For these investors, buybacks are a mixed blessing. On the minus side, at some growth companies, the announcement of a buyback is a signal that the days of heady growth are over and that the company is approaching a more mature status. That would be a signal to sell. On the plus side, the use of buybacks may allow some mature companies to become growth investments. How? A growth investor who holds on to his shares will get price appreciation as other investors tender their shares. Bottom line: Look for mature companies where buybacks offer the most price appreciation potential. In general, these will be companies that are perceived to have few growth opportunities and have significant debt capacity. At growth companies, reassess prospects for the future on the announcement of a buyback. The price bounce after a buyback may offer the perfect exit strategy.

No matter what type of investor you are, you need to be aware of when and how much companies are buying back. Unfortunately, both conventional print media (Wall Street Journal, Financial Times) and data services (Yahoo! Finance, Morningstar etc.) seem to pay little heed to buybacks. While it is possible to extract the raw data from the statement of cash flows, I think that adding an augmented dividend number would be a step in the right direction.

Professor, do you have your own article or some recommendation about an impact of new share issues (with various price levels) on stock price of the company. You talked about an impact of decreasing of the number of shares of a company, but what about an opposite example? Thx very much in advance...

For what it's worth, I think a lot of the debate on buying in stock misses the forest from the trees. Quite simply, a buyback is a good idea if the shares are undervalued and a bad idea if they are overvalued. Unfortunately, most managements tend to be better operators than capital allocators so they tend to buy in stock at the wrong time. I believe generally though that a buyback at a cheap price is superior to a dividend because of the tax ramifications of dividends... - Adrian Meli

Adrian,Fair enough. If that is the primary rationale, though, it is clear that companies have no idea what they are doing. They seem to buy back far more stock when prices are high than when they are low. And I agree with you... Managers at not very good at assessing the value of their own stock. Perhaps, it is difficult for them to be objective.

If you take stock buybacks to an extreme, management would essentially be purchasing the company's entire share base.

E.g. if the company boughtback sufficient shares so that only 100 holders remained (1 share each), then they would be holding a stock with a pretty high price. I think owning 1% of an S&P500 company would be pretty nice.

I think Steve Wynn had an extremely savy response and approach to buybacks:

[Responding to a question as to why Wynn issued equity at $154 at the end of September and then paid a dividend of $6/share on December 10th. Note that Wynn shares had traded in the $80s in June of last year and at $120 yesterday.]

"It is the job, and you can take this as a final statement on the subject going forward. It is the job of board of directors and especially of the CEO to take advantage of the market when that market movement is extreme. When a company increases its value by 100% in 60 days, that’s an unnatural movement of value and the market also goes the other way sometimes. These unnatural movements in value, no company gets to be worth twice as much in 60 days as it was before to any intelligent person, so when that happens, we take advantage of it. If everybody is so hungry for shares, we let them have some. If the shares go down, we buy them. And that, that is a statement of policy in this company, period."

Otherwise, when I worked as a credit banker, we helped firms raise debt to fund buybacks, up-to and through 2006. In hindsight, levering-up for a non-"productive" investment at the height of a bubble was not such a bright idea...

I suppose this situation is going to change soon, because media try to follow trends, so they'll pay more attention to buybacks

>buyback is a good idea if the shares are undervalued and a bad idea if they are overvalued. Unfortunately, most managements tend to be better operators than capital allocators so they tend to buy in stock at the wrong time.

This is an old idea. Warren Buffett wrote this in his "Essays on Investing" many years ago. It's a good way to evaluate company's managers intelligence and "honesty"